My money is on 50 basis points at the Fed’s December meeting. Contrary to the now red-faced predictions of the GaveKal crowd, inflation, even by their favored indicators, has not abated, despite the total chaos in the private market for loans. Inflation is still accelerating, according to CPI-U, PPI, and chained PCE, the three big inflation indicators.
Source: Cleveland Fed
While I expect the dollar’s cratering to reflect itself in higher inflation going forward (loss of value of a currency is inflation, after all, and if markets are efficient, the forex change will ricochet its way down through all other prices), eurozone inflation is at a 6-year high. The ECB is in no position to cut rates. However, stresses on the Euro union have become very acute, especially among the “PIGS” (Portugal, Italy, Greece, Spain), plus France and Belgium, which do not fit so well into the acronym. Belgium has not even had a government for six months. Italy’s presidency and half its cabinet ministries are controlled by communists (yes. Communists.) However, the ECB and the Bank of England appear determined to hold their rates steady. My guess is that the ECB will ultimately acquiesce to 4-6% inflation in order to keep the union glued together.
The euro is currently undergoing its first existential test. The Fed’s depreciation of the dollar (to which the Chinese yuan is pegged), while not changing the balance of Chinese-US trade, has dramatically widened the euro-yuan differential. Chinese exports are flooding into Europe and crushing the lower-end “Club Med” (PIGS plus France). As evidenced by the explosion in spreads of French and PIGS bonds over German bunds, the market has begun to price in the possibility of a fracturing of the eurozone.
Meanwhile, the Chinese government is dealing with massive inflows of liquidity.
The PBoC has not only to mop up an expected $30-40 billion of foreign currency inflows every month, a Herculean task as it is (October’s reserve increase was $21 billion, probably low because of transfers to the CIC, but it has averaged $39 billion a month in 2007), but it must add to the mop-up the maturing of a substantially larger amount of maturing central bank bills during the next four months.
But there’s more. Wright argues that the maturing of repurchase agreements will add another RMB 250 billion over the four months, bringing the total amount of money entering the system to nearly $60 billion a month, not counting the PBoC purchase of net foreign currency inflows, which could mean managing $80-100 billion a month of new liquidity. In addition the recent amount and structure of fiscal revenues will add to the liquidity far more than it normally does. Wright explains:
Fiscal revenue is sky-high this year, up from last year’s total of 3.87 trillion yuan to an estimated 5 trillion yuan this year, according to a report from Yao Jingyuan, chief economist of the National Bureau of Statistics, cited in the Shanghai Securities News on November 26. The targeted revenue level was 4.4 trillion yuan.
Fiscal revenue went up from RMB3.9 trillion to RMB5trillion. That’s a 27.5% increase in one year.
Taxes are a good “floor” for economic statistics. People do everything they can to avoid taxes, so if taxes go up by a certain amount, you can bet that, all else being equal, liquidity rose by about that amount. That’s simply a staggering increase.
The Chinese government is facing extremely high domestic inflation. Bernanke, by depreciating the dollar, has effectively raised the price of Chinese currency policy and raised future Chinese inflation. Chinese monetary authorities, especially Zhou Xiaochuan, see an RMB revaluation as urgent (if not extremely so), but China’s regional economies are completely addicted to artificially cheap currency. A one-off 20 percent revaluation would probably see the collapse of tens of millions of jobs’ worth of businesses, which would probably stoke as much domestic unrest as exponentially increasing inflation. Politically the Chinese do not seem able or willing to revalue their currency, even as Bernanke has turned the screws.
Six months ago, I would have said that the dollar or the yuan needed to break. Today, the same either/or applies to the yuan and the euro. Until one of those break points occurs, the global financial party will go on. The euro cannot carry the weight that the dollar did, because European manufacturers will not stand for it. But for a while, the euro will be “the overvalued currency” which the dollar was in 1998-2005.
I expect all asset classes, especially metals, oil, gold and Chinese equities, to reflate until that break point occurs–which would be signalled by either 1) a widening of Italian, Belgian, Greek and/or Portuguese (probably Italian) bond spreads to over 80 bps over German bunds, the precedent for a eurozone breakup; or 2) in the case of China, massive and coordinated riots over food or fuel, both of which have been aggressively rationed to hold down official inflation numbers.
I expect the dollar to generally continue skidding downwards, and I believe a sudden rise of dollar will be the canary in the coal mine for a crackup in either the eurozone or the Chinese bubble.
I see oil as especially prone to another spike, because of geopolitical factors. As I have noted in previous posts, Russia (which is heavily invested in prolonging Mideaster turmoil) will begin the countdown to war with Iran if it delivers nuclear fuel to Bushehr. Even though these kinds of impending crises are almost always muddled through, local factors make that less likely, and the significant rise in the probability of war will severely rattle the oil market.
The bottom line is that there’s a worldwide inflation glut: even Japan is recording meaningful inflation (from fuel costs), and the thinking is that Japanese competition is causing a lot of Japanese companies to eat price increases instead of passing them on to consumers. If you compensate for that, even Japan is experiencing accelerating inflation.
In the medium term, states with large cash reserves will become increasingly uncomfortable with the value of said cash as Bernanke insanely continues to plunge rates to bail out the US financial industry. Cash hoarders will continue converting into gold, with Russia leading the way.
I am bullish on the commodities currencies, still–especially the ruble. But why buy the paper when you can just buy the underlying commodity itself and not have your asset stolen from you.
I think equities can’t do too badly in an inflationary environment, especially exporters. (Note that the GM/F/Chrysler liabilities will depreciate more as inflation rises, and as the value of the dollar goes down their exports will rise significantly). However, I also think equities markets will have this jittery “recession just around the corner” mentality, as worldwide inflation and pain aversion keeps the world economy on the cusp of a bubble that theoretically is only about three central bank decisions away from being popped.
Also, there is a long stream of bad news from the banking sector on the way, and that has a big multiplier effect on other sectors. Bernanke is obviously scrambling the helicopters to carpet-bomb the banks with money as fast as he can, but the banks’ problems are (I believe) far beyond Bernanke’s power to help, and the problems will get worse in light of the recent “mark to reality event” at E*Trade. Mike Shedlock explains:
Financial analysts on Friday said E*Trade got anywhere from 11 cents to 27 cents on the dollar for its $3.1 billion portfolio of asset-backed securities. The portfolio sale was part of a $2.5 billion capital infusion from a group led by hedge fund Citadel investment Group.
“The portfolio sale, one of the few observable trades of such assets, has very clear, generally negative, implications for the valuation of like assets on brokers’ balance sheets,” Credit Suisse analyst Susan Roth Katzke said.
Citigroup investment bank analyst Prashant Bhatia said E*Trade actually received 11 cents on the dollar for its portfolio, if you factor in that the brokerage received $800 million in cash minus 85 million shares it issued. He said that implies Citadel’s received stock compensation worth about $450 million, leaving E*Trade with only $350 million for its $3.1 billion portfolio.
Goldman Sachs analysts said they were surprised by the size of the discount on the E*Trade portfolio because 73 percent of the assets were backed by prime mortgages, or loans to people with solid credit.
While admitting using simplistic analysis Credit Suisse analyst Susan Katzke estimates the following writedowns based on what happened at E*Trade, assuming pricing at 26 cents on the dollar.
- Merrill Lynch (MER) could take a $9 billion after-tax hit to the valuation of assets underpinned by subprime mortgages.
- Citigroup’s (C) after-tax write-down could be $26 billion.
Note that in reference to Merrill Lynch, Susa Katzke said $9 billion was related to subprime. Note that 73% of E*Trade’s portfolio was prime. That is quite a haircut on so called prime paper.
And I think bonds are going to get hammered. Bloomberg notes that yields on 10-year Treasuries are practically even with consumer price inflation, and also notes the widespread skepticism that those numbers are rational and justified. Inflation has not abated at all, and in light of that, bonds are not going to represent safety.
So basically, I’m bullish on gold.